Grief isn't rational. Give them the teddy back. The only reason you don't want to is because you're scared your child won't sleep and that's your problem not theirs.
That's a very unpleasant thing to say.
Whatever the rights and wrongs of the deceased lady's daughter wanting the teddy, it is far from unusual for a child to latch on to a specific teddy or blanket and to want to cuddle it when they sleep or are upset - and to be inconsolable if they can't have it for any reason. 2 is certainly not too young for the attachment to be formed or for the child to not notice if her possession is taken from her.
Just because she is only 2 does not mean that the little girl is not deserving of respect. She has been given a present and told it is now hers. Somebody else (not the giver who, I assume, owned it/bought it and therefore had the right to give it away) has asked for it.
What lesson does it teach her if her treasured possession is simply taken away from her (whether directly or by trying to fool her, as some PPs have suggested) - just because somebody believes that they want it more than she does? At what age is she supposed to assume that a person is allowed to gain rights over their own property?
Of course, the teddy doesn't have much intrinsic financial value, but it is dearly loved by the little girl - as she uses it to comfort herself when she sleeps. How is that any less important than if, say, it had been a valuable car given to the little girl's DM, who dearly loved it and used it to travel around everywhere in - and the giver's relative asked for it back?
The only person who should really decide whether to give the teddy away (not 'back', unless there are crucial details that haven't been given) is the girl who owns it.
If the bereaved daughter is a child herself, then maybe she could talk simply to the little girl and tell her why it means so much to her - more than anything else her DM owned. If she is an adult (and assuming that the teddy was bought relatively recently and isn't her own childhood comforter), she really should just accept it.
Is OP coming back at all?